Monday 27 September 2010 16.29 EDT
First published on Monday 27 September 2010 16.29 EDT

George Osborne tonight seized on the International Monetary Fund's upbeat assessment of the UK as an economy "on the mend" to underline the need for next month's tough austerity package.

The chancellor said a report by the fund showing that the UK needed a dose of belt-tightening was a "very welcome endorsement" of the government's budget strategy.

"They [the IMF] have made it pretty clear that the deficit reduction plan that we have set out is essential for bringing about sustainability in our budget," the chancellor told the BBC. "It reminds us that if we divert from the course the new government has set out then we really will be heading back into a disastrous period of economic instability for Britain."

Osborne said the IMF's endorsement chimed with support for the government from the Organisation for Economic Cooperation and Development, the European commission, the CBI and the governor of the Bank of England.

After a two-week fact-finding mission to the UK, the three-man IMF team said: "The UK economy is on the mend. Economic recovery is under way, unemployment has stabilised, and financial sector health has improved."

Osborne announced £6bn of spending cuts within a week of becoming chancellor, raised taxes in an emergency budget in June and is preparing the toughest round of cuts since the war in next month's comprehensive spending review.

The IMF study said plans to cut public spending and raise VAT to 20% in January were unlikely to slow growth, but it believes the Bank of England should stand ready to pump more money into the economy through quantitative easing should the economy slow more than expected.

"The government's strong and credible multi-year fiscal deficit reduction plan is essential to ensure debt sustainability," the IMF said. It advocated the end of universal state benefits and cuts in public sector pay and pension entitlements to bring down record peacetime borrowing, which rose to more than £160bn last year.

"The plan greatly reduces the risk of a costly loss of confidence in public finances and supports a balanced recovery. Fiscal tightening will dampen short-term growth but not stop it as other sectors of the economy emerge as drivers of recovery, supported by continued monetary stimulus."

After discussions with the Treasury, the Bank, the CBI, unions and thinktanks, the IMF team said recovery would proceed at a moderate pace, with growth of 2% in 2011 rising to 2.5% in the medium term.

While there were risks that the economy could perform less strongly than expected "given the continued fragility of confidence, still-strained balance sheets among households and banks, signs of renewed housing market weakness, and the possibility that headwinds from fiscal consolidation could turn out to be more powerful than expected", there were also reasons why it could be stronger.

The Bank of England would need to be "nimble" if the impact on growth of budget cuts was more severe than expected. There was no reason why interest rates needed to rise from 0.5%.

The government was warned against getting cold feet about bank reform. "The UK authorities should continue to provide leadership and build support for ambitious global reform of financial regulation. Ensuring a smooth transition to a new supervisory architecture at home will also be important to secure a safer post-crisis environment."

The fund saw no evidence of a double-dip recession. "Households are likely to remain thriftier than before the crisis but will be in a position to gradually raise their consumption as labour markets recover."

Amid signs over the past two months that the pace of growth has slowed since the middle of the year, the fund said Osborne's plan to balance the government's cyclically-adjusted current budget (the running costs of the state adjusted for the state of the economy) by 2015-16 was "appropriately ambitious".

It added: "The consolidation plan and implementation of early measures to tackle the deficit – one of the highest in the world in 2010 – greatly reduces the risk of a costly loss of confidence in fiscal sustainability and will help rebalance the economy. These benefits outweigh the expected costs in terms of adverse effects on near-term growth."